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Clarifying the Swa(m)p: Margin Requirements for Uncleared Swaps

As required by the Dodd-Frank Act, the CFTC has published for comment proposed initial and variation margin requirements for uncleared swap transactions involving CFTC-regulated swap dealers (“SDs”) and major swap participants (“MSPs”). In its proposing release, the CFTC explicitly states it is not imposing margin requirements on non-financial end users.

Photo by Antonio Jimeno Parra. Some rights reserved.

Who is Affected. The CFTC’s proposal would apply to those CFTC-registered SDs and MSPs that are not banks, including nonbank subsidiaries of bank holding companies regulated by the Federal Reserve Board. In addition, certain swap activities currently engaged in by banks and which may be conducted in nonbank subsidiaries and affiliates as a result of prohibitions in the Dodd-Frank Act, may be subject to the CFTC’s rules.

Market Participants. The margin required, and how that margin is calculated, will vary depending on the parties involved. The proposal envisions three types of counterparty: another SD or MSP; financial entities; and non-financial entities. Initial margin must be collected, and variation margin maintained, for every uncleared swap with another SD or MSP, although a de minimis exception for transaction under $100,000 exists.

Similarly, initial margin must be collected and variation margin maintained for every uncleared swap with a financial entity. Financial entities include banks, commodity pools, employee benefit plans, private investment funds, and any other entity so-designated by the CFTC. Zero thresholds would be allowed for certain financial entity counterparties who are subject to prudential regulation.

No margin requirements exist for transactions involving non-financial, commercial end-users. However, credit support arrangements must be in place, as in any swap transaction, and hypothetical initial and variation margin must be calculated.

Calculating Initial Margin. Initial margin can be calculated using models meeting the following standards: (i) a model currently in use for margining cleared swaps by a derivatives clearing organization (“DCO”); (ii) a model currently in use for margining uncleared swaps by an entity subject to regular assessment by a prudential regulator; or (iii) a model available for licensing to any market participant by a vendor. Because the CFTC lacks the resources to review individual models, the use of proprietary models would not be permitted. Models would have to be filed with the CFTC, could be rejected by it, or required to be modified.

If a model does not exist, the margin requirements for a similar cleared swap could be used. Explanations would be required and a multiplier imposed.

At any time the CFTC could require additional margin be posted.

Comments should be submitted on or before June 27, 2011. View the proposal here.